As you begin a new job, or if you are a longer-term employee who is just starting to make contributions to a 401(k) plan, you are confronted with a question:  How does a contribution to the 401(k) plan impact the final take home pay on my paycheck? Believe it or not, you could actually increase your bottom line assets by reducing your income through a 401(k) contribution.

Let’s work through an example so that we can more completely understand what happens.

Your New Job

So, you’ve started a new job, with an annual pay of $30,000.  We won’t go into all of the details behind a W4 at this point, but for the sake of the example, we’ll say you filed your W4 to exactly match your tax expected of $2,603 for the year (and you started in January).  In addition to this, you have opted to take advantage of your employer’s health insurance plan, which costs $50 per month.  You are paid on an every-other-week schedule, for 26 pay periods per year.

This means that your take-home pay amounts to approximately $884.82, which is calculated as follows:

Your 401(k)

So, you now are ready to begin making contributions to your available 401(k) plan.  The company will match your contributions as follows:

100% of the first 2% of contributions

50% of the next 2% of contributions

25% of the next 2% of contributions

If you make a total of 6% in contributions, the company will match that with 3.5% contributed to your account.  Your 6% of $30,000 will amount to $1,800 per year, and the company match will be an additional $1,050, for a total contribution of $2,850.

For each paycheck, you are making a contribution of 6%, which is $69.23, and the company’s match is an additional $40.38 added to your account.  The result in change to your paycheck will work out as follows:

The difference in your final take-home pay is only $55.48, which is $13.75 less than the amount that you contributed to the 401(k) account.  This is due to the fact that when you make a contribution to the 401(k) account, this amount is no longer subject to income tax.

When you consider what your overall economic result from this new paycheck is, you’ll see that making the 401(k) contribution is, indeed, a no-brainer:

As you can see, the end result is that you actually have increased your overall money on your balance sheet assets by $54.13, which is a 6.11% increase.  Granted, your 401(k) account and the company match are restricted in access, but your overall situation is a significant increase.

Keep in mind that, while we used 401(k) as the example type of account, the same could apply to a 403(b), or other sort of tax-deferral account.

You can pick up my book, An IRA Owner's Manual, in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

As you prepare your tax return, you have a decision to make about your tax deductions – you can choose between itemizing and using the standard deduction.  But how do you choose?

The Standard Deduction is just what it sounds like – a standardized deduction that you can choose to utilize by default, and you don’t have to do a lot of recordkeeping through the year in order to use the the standard deduction.  In order to itemize deductions, you need to save receipts from various deductible expenses through the year, and use those to prepare your itemized return.

The IRS recently published their Tax Tip 2012-43, which has some good information to help you with this choice.  Oftentimes it is a foregone conclusion, once you understand the differences between itemizing and the standard deduction.  Below is the text of the Tax Tip.

Standard Deduction vs. Itemizing: Seven Facts to Help You Choose

Each year, millions of taxpayers choose whether to take the standard deduction or to itemize their deductions.  The following seven facts from the IRS can help you choose the method that gives you the lowest tax.

1. Qualifying expenses – Whether to itemize deductions on your tax return depends on how much your spent on certain expenses last year.  If the total amount you spent on qualifying medical care, mortgage interest, taxes, charitable contributions, casualty losses and miscellaneous deductions is more than your standard deduction, you can usually benefit by itemizing.
2. Standard Deduction amounts- Your standard deduction is based on your filing status and is subject to inflation adjustments each year.  For 2011, the amounts are:
   • Single, $5,800
   • Married Filing Jointly, $11,600
   • Head of Household, $5,800
   • Married Filing Separately, $5,800
   • Qualifying Widow(er), $11,600
3. Some taxpayers have different standard deductions – The standard deduction amount depends upon your filing status, whether you are 65 or older or blind and whether another taxpayer can claim an exemption for you.  If any of these apply, use the Standard Deduction Worksheet on the back of Form 1040EZ, or in the 1040A or 1040 instructions.
4. Limited itemized deductions – Your itemized deductions are no longer limited because of your adjusted gross income. Note from jb: previously, at higher levels of income a taxpayer’s itemized deductions could be limited.  This limitation has been eliminated – but it could come back for future tax years.
5. Married Filing Separately – When a married couple files separate returns and one spouse itemizes deductions, the other spouse cannot claim the standard deduction and therefore must itemize to claim their allowable deductions.
6. Some taxpayers are not eligible for the standard deduction – They include nonresident aliens, dual-status aliens and individuals who file returns for periods of less than 12 months due to a change in accounting periods.
7. Forms to use – The standard deduction can be take on Forms 1040, 1040A, or 1040EZ.  To itemize your deductions, use Form 1040, US Individual Income Tax Return, and Schedule A, Itemized Deductions.

You can pick up my book, An IRA Owner's Manual, in either the print version or the Kindle version by clicking the links.
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• New this year! Take a one-time opportunity to reduce your self-employment taxes – In addition to the standard ‘above the line’ deduction described below, self-employed persons can also deduct the cost of their health insurance premiums from their self-employment taxes on Schedule SE. This is a one-time-only opportunity available for 2010 taxes, so if you’re self-employed be sure to take advantage of it.
  

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• Deduct health insurance premiums as a business expense – If you had self-employment income, you may also be able to deduct health insurance premiums you paid for yourself and your dependents as an ‘above the line’ business expense (that is, without itemizing) on your federal tax return.  Be aware, however, that you may not deduct premiums paid for any month in which you were eligible to participate in an employer-sponsored health insurance plan, and that the amount you deduct cannot be greater than your net self-employment income for the year.  Also, keep in mind that you may not be able to include what you paid toward your monthly premiums as an ‘above the line’ expense AND itemize it as described in the next tip. Talk to a tax professional to learn more about the different types of self-employment status and the tax implications of each in your state.
• Itemize your health insurance and medical expenses – Even if you’re not self-employed, if you itemize on your federal tax return you may be able to deduct medical expenses from your taxable income. According to IRS Publication 502, qualifying medical expenses include monthly premiums you pay for coverage (including some Medicare premiums), copayments, deductibles, dental expenses, and costs for some services not covered by your insurance plan. Keep in mind: you can only deduct the portion of your medical expenses that exceeds 7.5% of your adjusted gross income. That means this deduction isn’t for everyone, but if you (or one of your dependents) were seriously ill or hospitalized last year – or if you paid COBRA premiums (without receiving federal subsidy), you may qualify.
• Maximize your refund with your Health Savings Account (HSA) – An HSA is a tax-advantaged savings account used in conjunction with an HSA-eligible health insurance plan. Account contributions, qualified distributions and earnings are all tax-exempt. An HSA allows you to deposit a portion of your pre-tax income into a savings account and use those funds to pay for qualified medical expenses.  Unused money can be invested and accrue from year to year. If you have an HSA, be sure to deduct your contributions up to federally prescribed limits.  Contributions to your HSA designated for 2010 and made before April 18, 2011 can be counted toward your 2010 federal taxes.  According to IRS Publication 969, HSA contributions for the 2010 tax year are capped at $3,050 for individuals and $6,150 for families.
• Be aware of how the COBRA subsidy may alter your taxable income – Persons enrolling in COBRA as the result of a lay-off after June 1, 2010 no longer qualified for the 65% federal COBRA subsidy, but plenty of people who did qualify for the subsidy were still receiving it in 2010.  If you received the COBRA subsidy, your taxable income may increase depending on how much money you made in 2010.  If your adjusted gross income was between $125,000 and $145,000 ($250,000 – $290,000 for those filing joint returns), you may only be eligible to retain a portion of that subsidy. If your adjusted gross income was greater than $145,000 ($290,000 for joint-filers), you are not eligible for the subsidy and should review your tax liability for the subsidy carefully.

Please note that the provisions discussed above may apply differently to you based upon your circumstances, and your local certified public accountant or tax professional will be able to advise you in light of those circumstances.

You can pick up my book, An IRA Owner's Manual, in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

The way these plans work is that you voluntarily decrease your income by a certain amount, generally paycheck by paycheck, and that amount is placed in a separate account.  Over the course of the calendar year, you can request reimbursement from your FSA funds for qualified expenses that you’ve incurred.

If it’s a health-care FSA account, you can request reimbursement for your healthcare deductibles, co-payments, and co-insurance costs – literally any health-care expense that is not covered (paid) by other insurance.  There are limits, though: beginning with 2011, you cannot be reimbursed for non-prescription (over the counter) medications.

If the FSA account is for dependent-care expenses, you can request reimbursement for your qualified child-care or adult daycare expenses for your dependents.

The income that you have diverted into the FSA account is pre-tax (just like your 401(k) contributions), so your income is reduced when you participate in these plans.  The income is still subject to Social Security and Medicare tax, but not ordinary income tax.

Generally speaking, most FSA plans are set up to allow for a 2½ month grace period for reimbursement from the plans.  This means that, for any particular calendar year that you are participating in a FSA plan, you must request reimbursement of your funds by March 15 of the following year.  If you do not request your funds by this deadline, you lose the opportunity to retrieve these funds forever.

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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

However, there is a way to get the over-the-counter (OTC) drugs that your physician recommends and use your FSA funds to pay for it… if your physician gives you a prescription for it.  Even though the IRS has disallowed the use of FSA funds for OTC drugs, if your physician gives you a prescription for the OTC drug, your FSA can be used to pay for the drug.

There are some rules though:  first, the prescription has to provided to the pharmacist prior to the purchase, and the pharmacist must dispense the drug just as if it were a regular prescription, with a Rx number assigned to the prescription.  The records must be maintained by the pharmacy and the taxpayer and available to the IRS if necessary.  FSA debit cards (and HSA debit cards) can also be used for this purpose, as long as all of the requirements are met.

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You can pick up my book, An IRA Owner's Manual, in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

Tax on Health Insurance

The claim: Beginning in 2011, you’ll be taxed on the value of your employer-provided health insurance.

There are several email campaigns making their way around right now claiming that, beginning in 2011, taxable income on Forms W-2 will be increased to reflect the value of employer-provided health insurance.  A typical email warns: “You will be required to pay taxes on a large sum of money that you have never seen.  Take your last tax form and see what $15,000 or $20,000 additional gross income does to your tax debt.  That’s what you’ll pay next year.  for many it also puts you into a new higher bracket so it’s even worse.  This is how the government is going to buy insurance for the 15% who don’t have insurance and it’s only part of the tax increases.”

The facts: While it’s true that, beginning in 2011, the health-care reform legislation requires employers to begin reporting the cost of employer-provided health-care coverage on an employee’s Form W-2, the cost is included for informational purposes only, to show employees the value of their health-care benefits.  The amount reported is not included in income, and will not affect your tax liability.

Sales Tax on Real Estate

The claim: Beginning in 2013, a new federal sales tax will apply to the sale of a home.

The claim is that, beginning in 2013, all real estate sales will be subject to a new 3.8% federal sales tax.  The emails making this claim generally contain some variation of the following text:  “Under the new health-care bill – did you know that all real estate transactions are now subject to a 3.8% sales tax?  The bulk of these new taxes don’t kick in until 2013… if you sell your $400,000 home, there will be a $15,200 tax.”

The facts: This claim, though inaccurate, has a basis in fact.  There is no federal sales tax being imposed on the sale of homes.  But, beginning in 2013, the health-care reform legislation does impose a new 3.8% Medicare contribution tax on the net investment income of high-income taxpayers (individuals with adjusted gross income (AGI) exceeding $200,000, and married couples filing joint returns with AGI exceeding $250,000).  Net investment income will include only gain on the sale of a home.  However, the tax will not apply to any gain that is excludable from income.  Individuals, if they qualify, can generally exclude the first $250,000 in gain on the sale of a principal residence, while married couples filing jointly can generally exclude up to $500,000.  That means that in most cases, at least where a principal residence is concerned, the 3.8% tax would kick in only if your AGI exceeds the threshold above and only if profit on the sale of the home exceeds $250,000 ($500,000 for couples filing jointly).

In Closing

These two claims are good examples of how things can get out of hand when the complete facts aren’t fully understood.  The only way to completely understand what’s going on with the new law is to educate yourself – and to use trusted sources when educating yourself.  It’s important to know that not all emails and internet articles are to be fully trusted.  Know the source of the communication – and make sure that it’s someone you can trust to give you the complete picture.  And if you want to get a second opinion on something you’ve read, just let me know.  I’ll be happy to help out, as always.

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You can pick up my book, An IRA Owner's Manual, in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

In the past, these plans have been eligible to reimburse the owner of the account for a myriad of medical expenses, not only physician expenses, prescription drugs, and other health care expenditures, but also over-the-counter medicines or drugs (not controlled by prescription).

Beginning in 2011, due to the Affordable Care Act, over-the-counter drugs and medicines that are not ordered by prescription will no longer be eligible for reimbursement from a medical Flex-Spending plan.  The change does not affect insulin, even if purchased without a prescription, or other health care expenses such as medical devices, eye glasses and contact lenses, co-pays and deductibles.

This new standard goes into effect for purchases made January 1, 2011 or after, and a similar standard is due to be in place for Health Savings Accounts (HSAs) and Archer Medical Savings Accounts (Archer MSAs).  But never fear, reimbursements are still going to be available for your 2010 expenditures through March 2011 as always.

If you have one of these FSAs, you’ve probably gotten into a situation in the past (I know I have) where you had too much money set aside through the year for your “regular” medical expenses, and so at the end of the year you make up the difference by stocking up on standard over-the-counter drugs and medicines.  This option will no longer be available to you at year-end in 2011.

Stay tuned as more of this quite helpful guidance comes along.  I’m sure we’ll be collectively satisfied with the results – or but then again, probably not.

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You can pick up my book, An IRA Owner's Manual, in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

Does This Make Sense?

The reason that the question of sense comes up is because when you are eligible to make contributions to your HSA, you can deduct those contributions from ordinary income.  In the case of the tax-free transfer, no deduction is allowed – in fact the income isn’t included at all, so therefore the deduction is lost.

For most folks, the deduction against earned income (above the line; that is, this deduction impacts Adjusted Gross Income and Modified AGI, therefore impacting all sorts of other calculations) is much more valuable than any benefit of a one-time tax-free transfer.

If the IRA is the only source of funds that you have available to make the contribution, you’re probably just as well off to take the distribution, pay the tax, and then take the deduction for the HSA contribution in most cases.  This option is available to you every year, not just once in your life.  If you are under age 59½ you will owe the 10% early withdrawal penalty in addition to the ordinary income tax, of course.

Other Than Most Cases

So when would it make sense to use this one-time tax-free transfer?  I can think of a couple of cases where this might be the right move:

1. If you are under age 59½ and you have no other funds available to make a contribution to your HSA, using the rollover/transfer from your IRA would bypass the 10% early withdrawal penalty.  I would think you’d want to make this your last resort if you’re in that position.
2. If you are in a position where you are eligible to take the distribution from your IRA (you’re over age 59½) but showing the income on your tax return will impact some other external calculation – such as financial aid for college, creditors, state income tax, or an ex-spouse.

Bottom Line

The bottom line of all this is: if you have other current income, use those funds to make your deductible HSA contribution.  If you have no other source of funds beyond your IRA and you are over age 59½, take the distribution from your IRA as taxable income and then make the HSA contribution from there.  As a last resort, if you are under age 59½ and have only your IRA as a source of funds to make a contribution to your HSA – then it might make sense to do the one-time IRA-to-HSA tax-free transfer.

NOTE:  It is important to note that this one-time option does not increase the amount that you can contribute to your HSA, nor does it allow you to make a contribution if you are otherwise ineligible to make such a contribution.

If you can think of other situations where the tax-free rollover from your IRA to your HSA might make sense, please leave a comment below!

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You can pick up my book, An IRA Owner's Manual, in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

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In Part 1 of this two-part article, we introduced the concept of the Health Savings Account.  In this portion, we’ll talk about some more of the specifics with regard to implementation of the plan, including contribution limits, setting up the plan, and taking distributions.

Contribution Limits on the HSA

The amount that you can contribute to a HSA annually depends upon the type of HDHP coverage that you have, as well as your age.  For 2010 and 2011, if you only have coverage for yourself, you can contribute up to $3,050.  If you have the family coverage, you can contribute up to $6,150.  You must have the HSA in place for the entire year to make the maximum contribution.

If you are at or above age 55 at any time during the tax year, you are eligible to contribute an extra $1,000.  You can make contributions to your HSA for a particular tax year up to April 15 of the following year (no extensions allowed).

For any month that you do not have your HDHP in place, the maximum contribution is reduced by 1/12. In addition to that reduction, the maximum amount that can be contributed to an HSA must be reduced by any:

• amounts contributed to an Archer MSA (including employer contributions; and
• any amounts that your employer contributed to an HSA on your behalf that were excluded from your gross income.

If you have more than one HSA, your total contributions to all HSAs in any given year cannot be more than the annual limit.  If you make contributions to one or more HSAs that are more than the annual limit, the excess will be included in your gross income and could be subject to a 6% excise tax.

The Impact of Marriage (well, one of them)

If either spouse has family coverage, both spouses are treated as having family coverage.  If both spouses have family coverage, you are treated as having family coverage with the lower annual deductible of the two plans.  The contribution limit is split evenly between the two of you by default – but different division amounts can be agreed upon as you see fit.

If both spouses are age 55 or better by the end of the tax year, each spouse can contribute the additional amount to his or her HSA.  For 2010, this would increase your maximum contribution limit for family coverage to $8,150.

Account Setup and Administration

You set up the HSA much the same as an IRA – you choose the financial institution (bank, insurance company, etc.) that you’d like to be your trustee, and simply open the account.

Rollovers can be done into your HSA from another HSA, an Archer MSA, or an IRA.  The IRA rollover is a one-time provision that was started with the passage of the Health Care Act of 2006.  In addition to the IRA rollover, the Health Care Act of 2006 also introduced the one-time rollover from a Flex-Spending Account (through tax year 2011) of one year’s HSA contribution amount, as long as you had at least that amount in your FSA prior to September 21, 2006.  For more information on the tax-free transfer from your IRA, see this article.

Distributions from your HSA

You can take distributions from your HSA to pay for or reimburse yourself for qualified medical expenses.  Qualified medical expenses are generally any medical expense that could otherwise be deducted when itemizing your deductions on your tax return (specified in IRC §213).  These distributions will be tax-free to you.  So, during the year, as you are paying for the expenses that make up the deductible amount for your HDHP, you could either take a withdrawal and pay the expense directly, or pay it yourself and reimburse yourself from the HSA.

Any amounts that you withdraw for other reasons beyond paying for or reimbursing yourself for qualified medical expenses will be subject to ordinary income tax and a 10% penalty (just like an IRA).

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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

HDHP Limits

First of all, the limits for a HDHP are as shown in the following table (2010/2011 figures):

**It should be noted that the Maximum Annual Deductible plus OOP only includes amounts paid within the defined “network” of providers authorized by the plan.  Any expenses outside that network will not be considered within this Maximum Annual amount.

In addition, some family plans have a separate Individual deductible and Family deductible.  When you meet the amount for the Individual deductible for one family member, you no longer have to meet the higher Family deductible for that year. If either the Family deductible or the Individual deductible are less than the minimums for that tax year, the plan does not qualify as a HDHP.

Colleague Mike Chamberlain had the following points to add:

Do not assume that just because your health plan was a high deductible that you are able to use an HSA.

If your plan had a $2000 deductible but paid for office visits and the deductible did not apply, you cannot have an HSA.

If you have a drug deductible that is not connected to the policy deductible it will not qualify either.

Most plans that do qualify state it in the name of the policy or boldly in the paperwork.

Thanks, Mike! — jb

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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).